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Accounting Conservatism and Performance Covenants: A Signaling Approach

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  • Jeffrey L. Callen
  • Feng Chen
  • Yiwei Dou
  • Baohua Xin

Abstract

This study examines the relation between performance covenants in private debt contracting and conservative accounting under adverse selection. We find that under severe adverse selection (i.e., high information asymmetry), accounting conservatism and performance covenants act as complements to signal that the borrower is unlikely to appropriate wealth from the lender. No such relation obtains in a low information asymmetry regime. We further show that in the high information asymmetry regime, borrowers with high levels of conservatism and tight performance covenants generally enjoy lower interest rate spreads than borrowers with low levels of conservatism and loose performance covenants. Consistent with our signaling theory, in the high information asymmetry regime, borrowers with high levels of conservatism and tight performance covenants are less likely to make abnormal payouts to shareholders. Our empirical results are robust to alternative measures of conservatism and covenant restrictiveness.

Suggested Citation

  • Jeffrey L. Callen & Feng Chen & Yiwei Dou & Baohua Xin, 2016. "Accounting Conservatism and Performance Covenants: A Signaling Approach," Contemporary Accounting Research, John Wiley & Sons, vol. 33(3), pages 961-988, September.
    • Handle: RePEc:wly:coacre:v:33:y:2016:i:3:p:961-988
    DOI: 10.1111/1911-3846.12208
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    Cited by:

    1. Urooj Khan & Alvis K. Lo, 2019. "Bank Lending Standards and Borrower Accounting Conservatism," Management Science, INFORMS, vol. 65(11), pages 5337-5359, November.
    2. Pappas, Kostas & Walsh, Eamonn & Xu, Alice Liang, 2019. "Real earnings management and loan contract terms," The British Accounting Review, Elsevier, vol. 51(4), pages 373-401.
    3. Feng Chen & Qingyuan Li & Li Xu, 2021. "Universal demand laws and the monitoring demand for accounting conservatism," Journal of Business Finance & Accounting, Wiley Blackwell, vol. 48(7-8), pages 1246-1289, July.
    4. Shai Levi & Benjamin Segal & Dan Segal, 2021. "Does fiduciary duty to creditors reduce debt covenant violation avoidance behavior?," Journal of Business Finance & Accounting, Wiley Blackwell, vol. 48(5-6), pages 929-953, May.
    5. Shankar Shaw, Tara & Raithatha, Mehul & Krishnan, Gopal V. & Cordeiro, James J., 2021. "Did mandatory CSR compliance impact accounting Conservatism? Evidence from the Indian Companies Act 2013," Journal of Contemporary Accounting and Economics, Elsevier, vol. 17(3).
    6. Adamu Pantamee Abdurrahman & Shafi Mohamad & Ooi Chee Keong & Syed Ehsanullah, 2020. "Debt Covenants and Accounting Conservatism," International Journal of Financial Research, International Journal of Financial Research, Sciedu Press, vol. 11(4), pages 537-545, July.
    7. Jacobo Gomez-Conde & Ernesto Lopez-Valeiras & Fabricia Silva Rosa & Rogério João Lunkes, 2023. "The effect of management control systems in managing the unknown: Does the market appreciate the breadth of vision?," Review of Managerial Science, Springer, vol. 17(8), pages 2769-2795, November.

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